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Homework #5 FIN 4504 Equity and Capital Markets Instructor: Cem Demiroglu Due: November 9, Tuesday 1.

The ______ average ignores compounding. A) geometric B) arithmetic C) both a and b above D) none of the above 2. The reward/variability ratio is given by __________. A) the slope of the capital allocation line B) the second derivative of the capital allocation line C) the point at which the second derivative of the investor's indifference curve reaches zero D) none of the above 3. The capital allocation line is also the __________. A) investment opportunity set formed with a risky asset and a risk-free asset B) investment opportunity set formed with two risky assets C) line on which lie all portfolios that offer the same utility to a particular investor D) line on which lie all portfolios with the same expected rate of return and different standard deviations 4. Risk that can be eliminated through diversification is called ______ risk. A) unique B) firm-specific C) diversifiable D) all of the above 5. Many current and retired Enron Corp. employees had their 401k retirement accounts wiped out when Enron collapsed because ____. A) they had to pay huge fines for obstruction of justice B) they had purchased fines for obstruction of justice C) their 401k accounts were not well diversified D) none of the above 6. Adding additional risky assets will generally move the efficient frontier _____ and to the ___________________. A) up, right B) up, left C) down, right D) down, left

7. The _________ could be used in an index model to represent common or systematic risk factors. A) firm size B) industry C) S&P500 index D) capital allocation line

8. Diversification is most effective when security returns are __________. A) high B) negatively correlated C) positively correlated D) uncorrelated 9. Beta is a measure of __________. A) firm specific risk B) diversifiable risk C) market risk D) unique risk 10. The risk that can be diversified away is ___________. A) beta B) firm specific risk C) market risk D) systematic risk 11. __________ is a true statement regarding the variance of risky portfolios. A) The higher the coefficient of correlation between securities, the greater will be the reduction in the portfolio variance B) There is a direct relationship between the securities coefficient of correlation and the portfolio variance C) The degree to which the portfolio variance is reduced depends on the degree of correlation between securities D) none of the above 12. Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always __________. A) equal to the sum of the securities standard deviations B) equal to -1 C) equal to 0 D) greater than 0 13. The term efficient frontier refers to the set of portfolios that _________________. A) yield the greatest return for a given level of risk B) involve the least risk for a given level of return C) Both a and b above D) None of the above answers are correct 14. Expected return-standard deviation combinations corresponding to any individual risky asset _________________. A) will always end up on the efficient frontier B) will always end up on the efficient frontier or within the efficient frontier, but never outside the efficient frontier C) will always end up within the efficient frontier D) may end up anywhere in expected return-standard deviation space

15. Portfolios that lie on the portion of the efficient frontier below the minimum-variance portfolio ___________________. A) add nothing to the investment opportunity set B) are sometimes useful in implementing sophisticated hedging techniques C) represent opportunities for arbitrage D) None of the above answers is correct 16. The slope of a capital allocation line measures the reward-to-variability ratio of ___________. A) all portfolios on the efficient frontier B) all portfolios on the capital market line C) the minimum variance portfolio only D) all portfolios on the particular capital allocation line in question 17. Rational risk-averse investors will always prefer portfolios ______________. A) located on the efficient frontier to those located on the capital market line B) located on the capital market line to those located on the efficient frontier C) at or near the minimum variance point on the efficient frontier D) Rational risk-averse investors prefer the risk-free asset to all other asset choices. 18. The optimal risky portfolio can be identified by finding _____________. A) the minimum variance point on the efficient frontier B) the maximum return point on the efficient frontier C) the tangency point of the capital market line and the efficient frontier D) None of the above answers is correct 19. Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return 10% and a standard deviation of return of 30%. The weight of security B in the global minimum variance is __________. A) 10% B) 20% C) 40% D) 60% Use the following to answer questions 20-22: An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 14% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is 50%. The risk-free rate of return is 10%. 20. The proportion of the optimal risky portfolio that should be invested in stock A is __________. A) 0% B) 40% C) 60% D) 100%

21. The expected return on the optimal risky portfolio is __________. A) 14.0% B) 15.6% C) 16.4% D) 18.0% 22. The risk-free rate of return is 10%. The standard deviation of return on the optimal risky portfolio is__________. A) 0% B) 5% C) 7% D) 20% Use the following to answer questions 23-25: An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 18% and a standard deviation of return of 20%. Stock B has an expected return of 12% and a standard deviation of return of 5%. The correlation coefficient between the returns of A and B is 50%. The risk-free rate of return is 10%. 23. The proportion of the optimal risky portfolio that should be invested in stock B is __________. A) .2000 B) .2667 C) .3636 D) .8000 24. The expected return on the optimal risky portfolio is __________. A) 13.2% B) 15.8% C) 16.4% D) 16.8% 25. The standard deviation of return on the optimal risky portfolio is approximately __________. A) 5% B) 7% C) 8% D) 9% 26. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20% while the standard deviation on stock B is 15%. The correlation coefficient between the return on A and B is 0%. The expected return on stock A is 20% while on stock B it is 10%. The proportion of the minimum variance portfolio that would be invested in stock B is __________. A) 6% B) 50% C) 64% D) 100%

27. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20% while the standard deviation on stock B is 15%. The expected return on stock A is 20% while on stock B it is 10%. The correlation coefficient between the return on A and B is 0%. The expected return on the minimum variance portfolio is approximately __________. A) 10.00% B) 13.60% C) 15.00% D) 19.41% 28. An investor can design a risky portfolio based on two stocks, A and B. The standard deviation of return on stock A is 20% while the standard deviation on stock B is 15%. The expected return on stock A is 20% while on stock B it is 10%. The correlation coefficient between the return on A and B is 0%. The standard deviation of return on the minimum variance portfolio is __________. A) 0% B) 6% C) 12% D) 17% 29. The systematic risk of a security __________. A) is likely to be higher in a rising market B) results from its own unique factors C) depends upon market volatility D) cannot be diversified away 30. Which of the following portfolios cannot lie on the efficient frontier? P o r t f oE l xi o p I 1 J 1 K 2 L Portfolio I Portfolio J Portfolio K Portfolio L e 8 6 5 5 c t e d S Rt a e n t % 1 % 2 % 2 % 3 u d 0 0 5 8 ra nr d % % % % D e v i a t i o n

A) B) C) D)

31. According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ and ___________. A) identifying all investor imposed constraints; identifying the set of securities that conform to the investor's constraints and offer the best risk-return tradeoffs B) identifying the investor's degree of risk aversion; choosing securities from industry groups that are consistent with the investor's risk profile C) identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion D) None of the above answers is correct

32. The values of beta coefficients of securities are ___________. A) always positive B) always negative C) always between positive 1 and negative 1 D) usually positive, but are not restricted in any particular way 33. A security's beta coefficient will be negative if _____________. A) its returns are negatively correlated with market index returns B) its returns are positively correlated with market index returns C) its stock price has historically been very stable D) market demand for the firm's shares is very low 34. In order to construct a riskless portfolio using two risky stocks, one would need to find two stocks with a correlation coefficient of _________. A) 1.0 B) 0.5 C) 0 D) -1.0 35. In standard deviation-expected return space, the market portfolio is found at ____________. A) the point of tangency with the indifference curve and the capital allocation line B) the point of highest reward to variability ratio in the opportunity set C) the point of tangency with the opportunity set and the capital allocation line D) the point of highest reward to variability ratio in the indifference curve Use the following to answer questions 36-40:

S R M R A S O

m m a r y O e g r e s s i o n u l t i p l e R S q u a r e d j u s t e d R t a n d a r d E r b s e r v a t i o n
Coefficients

t p u t t a t i s t i c s 0 . 3 5 0 . 1 2 S 0q . u 0 a 2 r e r 3o 8r . 4 5 s 1 2
Standard Error 15.44 0.97 t Stat 0.26 1.36 P-value .80 .10

Intercep t Market

4.05 1.32

36 .The beta of this stock is _____. A) 0.12 B) 0.35 C) 1.32 D) 4.05 37. This stock has greater systematic risk than a stock with a beta of ____. A) 0.50 B) 2.00

C) 4.00 D) all of the above 38. The characteristic line (SML) for this stock is Rstock = ___ + ___ Rmarket. A) 0.35, 0.12 B) 4.05, 1.32 C) 15.44, 0.97 D) none of the above 39. ____ percent of the variance is explained by this regression A) 12 B) 35 C) 4.05 D) 80 40. The nonsystematic risk for this stock is ____ percent. A) 12 B) 35 C) 38.45 D) none of the above 41. Decreasing the number of stock in a portfolio from 50 to 10 would likely to _____. A) increase the systematic risk of the portfolio B) increase the nonsystematic risk of the portfolio C) increase the return of the portfolio D) none of the above 42. Consider the CAPM. The risk-free rate is 6% and the expected return on the market is 18%. What is the expected return on a stock with a beta of 1.3? A) 6% B) 15.6% C) 18% D) 21.6% 43. Consider the CAPM. The risk-free rate is 5% and the expected return on the market is 15%. What is the beta on a stock with an expected return of 12%? A) .5 B) .7 C) 1.2 D) 1.4 44. The market portfolio has a beta of __________. A) -1.0 B) 0 C) 0.5 D) 1.0 45. In a well diversified portfolio, __________ risk is negligible. A) nondiversifiable B) market

C) systematic D) unsystematic 46. According to the capital asset pricing model, a security with a __________. A) negative alpha is considered a good buy B) positive alpha is considered overpriced C) positive alpha is considered underpriced D) zero alpha is considered a good buy 47. According to the capital asset pricing model, the expected rate of return on any security is equal to __________. A) [(the risk-free rate) + (beta of the security)] x (market risk premium) B) (the risk-free rate) + [(variance of the security's return) x (market risk premium)] C) (the risk-free rate) + [(security's beta) x (market risk premium)] D) (market rate of return) + (the risk-free rate) 48. According to the capital asset pricing model, fairly priced securities have __________. A) negative betas B) positive alphas C) positive betas D) zero alphas 49. The difference between a security's actual return and the return predicted by the characteristic line associated with the security's past returns is ___________. A) alpha B) beta C) gamma D) residual 50. The beta, of a security is equal to __________. A) the covariance between the security and market returns divided by the variance of the market's returns B) the covariance between the security and market returns divided by the standard deviation of the market's returns C) the variance of the security's returns divided by the covariance between the security and market returns D) the variance of the security's returns divided by the variance of the market's returns 51. According to the capital asset pricing model, __________. A) all securities must lie on the capital market line B) all securities must lie on the security market line C) underpriced securities lie below the security market line D) overpriced securities lie above the security market line 52. __________ is not a true statement regarding the market portfolio. A) All securities in the market portfolio are held in proportion to their market values B) It includes all assets of the universe C) It is the tangency point between the capital market line and the indifference curve D) It lies on the efficient frontier

53. __________ is not a true statement regarding the capital market line. A) The capital market line always has a positive slope B) The capital market line is also called the security market line C) The capital market line is the best attainable capital allocation line D) The capital market line is the line from the risk-free rate through the market portfolio 54. Security X has an expected rate of return of 13% and a beta of 1.15. The risk-free rate is 5% and the market expected rate of return is 15%. According to the capital asset pricing model, security X is __________. A) fairly priced B) overpriced C) underpriced D) None of the above answers are correct 55. If the simple CAPM is valid, which of the situations below are possible. Consider each situation independently. A)

E P o r t f o A B E P o r t f o A B E P o r t f o A B

x p e c t lR i o e t u r n 1 5 % 1 5 %

e d B e t a 1 . 2 1 . 0

B)

x p e c St e t da n d a r d l R i o e t u r Dn e v i a t i o n 2 0 % 3 0 % 1 5 % 3 5 % x p e c t lR i o e t u r n 2 5 % 5 % e d B e t a 1 . 5 0 . 5

C)

D) none of the above are possible 56. Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%. Portfolio X has an expected return of 14% and a beta of 1.00. Portfolio Y has an expected return of 9.5% and a beta of 0.25. In this situation, you would conclude that portfolios X and Y __________. A) are in equilibrium B) offer an arbitrage opportunity C) are both underpriced D) are both fairly priced